Currencies are traded in the global market at different time zones. And so, they have onshore and offshore markets. Does this sound confusing to you? Wait, we will explain things in detail to you – help you understand what onshore and offshore currency markets are and how traders trade in those.
Since currencies are an excellent asset class, adding currency into your portfolio will let you diversify it and optimise your profit-earning potential. But currency trading is a different league altogether. And, to start trading in the currency, you need to upgrade yourself about all its nitty-gritty.
Currency trading in the domestic market is quite straight forward. You can trade in currency derivatives in NSE or BSE exchanges. When currencies are sold within the local market, it is called an onshore market. The onshore market is regulated and monitored by market regulators like RBI and SEBI. But when foreign currencies are exchanged in the overseas market, it’s called offshore market. It is much more complicated and also, difficult to monitor, which is why regulators are wary of the offshore foreign exchange market.
Trading NDF Contracts In The Offshore Market
Currency trading is complicated. The fact that these can be traded in India and abroad makes it even more challenging to understand. Like, USD/INR futures contracts sold in the over the counter (OTC) market in London through NDF or non-deliverable futures contracts may be difficult for some people to grasp. But in reality, it happens daily. These futures contracts are traded in principally large finance markets of London, Singapore and Dubai or the neutral markets among foreign investors.
Mainly, non-deliverable futures traded in offshore foreign exchange. Now, you may ask what non-deliverable futures contracts are. Well, these are like other futures contracts, only that physical delivery of currencies doesn’t happen under these contracts. So, why do these exist?
NDF market typically develops for currencies where the local currency derivative market is underdeveloped, or traders are restricted by unfavourable tax structure. So, traders shift their focus to the NDF market, which grows in an offshore location.
Let’s understand NDF with an example. A foreign trader can’t trade in rupees and needs to settle deals in his native currency. Suppose he expects Indian rupee to depreciate against the dollar in the next three months and buys a forward for Indian money, which he settles in dollar due to convertibility restrictions. Hence, he deals in non-deliverable forward or NDF.
NDF contracts are futures contracts where participating parties settle the difference in NDF price or rate and spot rate at the predecided rate in the contract.
In an open and integrated market, most countries are now involved in export and import transactions, which require an exchange of foreign currencies. But as these markets grow, traders face challenges due to low accessibility and liquidity barriers. As a result, they shift to offshore locations where they can hedge against market exposure with minimum restrictions. Forex traders use NDF market to hedge their net possession on certain currencies which they can’t do in the domestic market.
Key players in the offshore currency market include the foreign banks, companies doing business in countries with foreign currency regulations, currency traders, hedge funds, commercial and investment banks.
Although offshore currency trading through NDF enjoys growing interest among investors, it’s not free from controversies. Trading in a foreign location makes it particularly challenging for regulators like RBI and SEBI to monitor, which is why the regulators are wary of offshore currency trading. Moreover, overseas markets also eat into the share of local market trading as big investors shift their deals to foreign locations where it is less regulated and cheaper. That is why the government is trying to amend its policies towards foreign exchange dealings to control the growth of offshore Indian rupees market.
Fabric Of The NDF Market
As we have discussed above, physical settlement of the asset never takes place in NDF trading. Two parties agree to settle the differences in rate, between the agreed price on contract and spot rate, in cash, preferably in US dollar. Hence, all deals in NDF market are quoted in USD.
Cash flow= (NDF Rate – Spot Rate )*Notional amount
These contracts are over the counter deals; quoted for a short duration between one month and one year. The contract mentions a currency pair, notional amount, fixing date, settlement date, and NDF rate.
The fixing date on an NDF is the same as the expiration date of a futures contract. On fixing date, NDF is settled on the spot rate of that day, and one party pays the difference to the other.
Let’s consider it with a real-life example. Suppose one party agrees to sell Indian rupees (buy USD) at the rate of 78 for USD 1million to another party which will buy rupees (sell USD). Now if rate changes to 77.5 in one month, meaning rupee apricates against the dollar, then the party who bought rupee will owe. Conversely, if the rupee depreciates to 78.5, then the party who is selling will owe to the other party.
The offshore currency market for NDF emerged during the 90s for Korean Won and Brazilian Real, but now other major foreign currencies also trade in it. There is a big market for offshore currency trading in Chinese Renminbi, Indian Rupees, Malaysian Ringgit, and more.
Spot traders, arbitrageurs, exporters and importers, scalpers, positional dealers are some of the key participants in the NDF market. Big players often enter both onshore and offshore currency markets at the same time.
Advantages Of The NDF Market
There are quite a few perks of trading in the offshore currency market, such as
- – It’s less stringent and beyond the purview of central bank and market regulators
- – Compliance requirements are less strict, making it easier for traders to enter
- – Exchange costs are avoided in offshore markets
- – Offshore currency market is active round-the-clock. With markets in Singapore, Dubai, and London it covers most of the time zones
- – Deals done in dollars make it a lucrative option for the traders
Concerns Over NDF Market
Concerns are rising over expanding offshore currency market. In the past, foreign currency market played a critical role in indicating the domestic market crisis. Both in 2013 and 2018, signs were present in the offshore market before the crisis hit the Indian economy. The change in sentiment in the overseas market lead to change in demand in the domestic market.
Also, differences in rates in the internal and offshore market give rise onshore-offshore currency arbitraging opportunities.
Thirdly, offshore market is less regulated and highly liquid, which means it can cannibalise the stringent domestic market as traders shift to NDF market to evade government regulations.
Even amid rising concerns over the offshore currency market, it is unavoidable. Since currency makes a great asset choice to diversify your portfolio, you can add it to amplify your profit earning. Even you limit your exposure to the domestic market, garnering a fair idea about how the offshore market works will help you make sensible speculations in the native market.